Question

Fairfax Paint operates stores in Virginia. The firm is evaluating the Vienna project, which would involve opening a new store in Vienna. During year 1, Fairfax Paint would have total revenue of 300,000 dollars and total costs of 225,000 dollars if it pursues the Vienna project, and the firm would have total revenue of 239,000 dollars and total costs of 184,000 if it does not pursue the Vienna project. Depreciation taken by the firm would be 64,000 dollars if the firm pursues the project and 35,000 dollars if the firm does not pursue the project. The tax rate is 20 percent. What is the relevant operating cash flow (OCF) for year 1 of the Vienna project that Fairfax Paint should use in its NPV analysis of the Vienna project?

Answer 1

Net present value= net present value of cash inflow - net present value of cash outflow

Note: In both the cases we are taking flat discount rate @10%

Formula= 1/ (1+ . 10) *1

If it pursues the vienna project:

Earning before tax = 300,000

(-) depreciation= (64, 000)

EBT after depreciation= 2,36000

(-) tax @20% = 47,200

Earning after tax and dep.= 1,88,800  

(+) depreciation= 64,000

Annual cash inflow= 2,52,800

* discount rate = 0.909

Net cash inflow= 2,29, 795

NPV = CASH INFLOW - CASH OUTFLOW

NPV= 2,29,795 - 2,25,000

NPV= 4,795

(Positive NPV) Here, we can pursues the vienna project.

IF IT DIDN'T PURSUE THE VIENNA PROJECT:

Earning before Tax= 2,39,000

(-) depreciation= 35,000

EBT after depreciation= 2,04,000

(-) tax @20%= 40,800

Earning after tax and dep. = 1,63,200

(+) depreciation= 35,000

Annual cash flow= 1,98,200

* discount rate= 0.909

Net cash inflow= 1,80,163

NPV= CASH INFLOW - CASH OUTFLOW

NPV= 1,80,163 - 1,84,000

NPV= -3, 837

(Negative NPV)